Deflation. There’s a concept we’ve not had to worry about in about three generations. While I think we are still pretty safe from a bout with deflation, we are closer to it now than in any time since before World War Two. As such, it probably makes sense to look at how you might be affected by deflation, if it were to occur.

First, let’s define what happens in a deflationary environment. In general prices drop, usually gradually, and consumers begin to defer purchases knowing that unless they really need something, they can probably buy it cheaper later. This is a concept that most owners of home computers know well. Now take that feeling and extrapolate it over a broad variety of goods including cars, furniture, appliances, leisure toys, pretty much everything. One key difference though is that with computers the technology improvements caused you to want to upgrade anyway, a feeling you won’t have when you look at your living room couch or washer and dryer. With deflation, people consume less, businesses sell less and workers loose their jobs as companies struggle to make a profit on lower sales.

So how does this directly impact you and your investments? Let’s look at them one by one.

STOCKS: As sales and profits drop, company earnings drop and marginal companies begin to go out of business. We’ve seen a taste of this in the Telecom industry over the past two years. As companies struggle they try to cut expenses and sell assets, which further depresses prices, and lay off workers which further curtails consumer spending. The biggest losers are companies that make or provide consumer discretionary items and services like cars, boats and home furnishings. The relative winners are companies that sell necessities like food and beverage companies, drug manufacturers and government suppliers.

BONDS: Corporate bonds and non-government guaranteed mortgages would suffer along with stocks because the credit worthiness of the borrowers will drop. While you may rightly argue that interest rates too will drop, it will not begin to compensate for the increased worry of default. Only bonds from the strongest and most recessionproof companies will do relatively well. Treasuries, on the other hand, will be big winners. Besides being very liquid, it’s the only investment that is guaranteed to pay you back in increasingly more valuable dollars and even pays you a return. In a deflationary environment it is the investor’s dream.

REAL ESTATE: Another place not to be. As workers loose their jobs and factories close there is suddenly a glut of real estate for sale. Especially hard hit are the first time home buyers and "McMansion" owners who get caught with too much debt and not enough staying power to keep from defaulting on their loans. Even those who keep their jobs are likely to see lower wages, which makes what once seemed like reasonable monthly loan payments untenable. The banks that made those loans have even bigger problems. Only those properties that have minimal and/or no debt and can cover their expenses at reduced revenues will survive.

CASH: When there is deflation, cash is king. People who have no debt and money in the bank are the biggest winners. There were vast fortunes made in the 30s by people who had sufficient resources to work for virtually no cash wages and take stock instead. When the economy recovered and deflation was gone they found themselves sitting on huge stock positions at just the right time.

As a parable to cash is king, debt is deadly. Being trapped in paying off large amounts of debt in increasingly more valuable dollars makes a loan with even the lowest interest rate too expensive.

NOW WHAT SHOULD YOU DO: While I don’t believe that a true deflationary environment is very likely, it does pay to keep your eye on the economic data and at least think about where you would stand if deflation did happen. First and foremost, watch your debt. If you’ve refinanced your mortgage make your old payment so as to pay it down faster. Don’t carry credit card debt of any kind. Defer the purchase of luxury and/or unnecessary items. This will both help you build your cash position and not saddle you with high-ticket assets that depreciate very rapidly. If you are really worried about deflation then upgrade the credit quality of your bond holdings and keep your cash in FDIC insured accounts or money market funds that invest primarily in short term governments. Also, make sure your equity holdings tend toward the conservative, dividend paying companies that have strong market positions and healthy cash reserves.

There are real opportunities to be had during periods of deflation. We are now about as close to seeing deflation as we have been in decades so it pays to give it some thought and be prepared just in case.

Please feel free to call me if you have any questions or concerns about this or any other financial matters.

Randy Gridley

November, 2002